A private equity firm is one who invests in the privately held equity of other companies – including those that own real estate. To do this, they typically utilize one of two deal structures: (1) an individually syndicated deal (which is our preferred type of investment); or (2) a fund.
In this article, we are going to describe how private equity real estate funds are structured, why it matters, and how they are categorized. By the end, the goal is for investors to be able to clearly identify the differences between a deal and a fund and to have the information needed to determine which is more suitable for their own preferences.
At First National Realty Partners, we are a private equity firm that specializes in the acquisition and management of grocery store anchored retail centers. Although we prefer the single deal structure to a fund, we believe it is important to understand both to allow investors to make the most suitable choice for their own needs. If you are an accredited investor and would like to learn more about our current opportunities, click here.
Private Equity Real Estate Funds vs. Individually Syndicated Deals
The best place to start the discussion on funds is to differentiate them from the types of individually syndicated deals that we offer.
In a fund structure, a fund sponsor leads a fundraising effort for a specific fund in which capital will be deployed under a specific investment strategy. In other words, investors allocate capital, but only for the purpose of general real estate investment. Specific properties are purchased in the future and investors generally have no say in which ones are pursued. For example, a private equity firm may raise funds for multifamily investment under the idea that they will use the capital to purchase apartment buildings in the future.
In a syndicated deal structure, the deal sponsor raises capital to purchase a specific property. In this case, investors know exactly which property is going to be purchased with their equity investment.
There are pros and cons to both approaches, but the focus of this article is private equity real estate funds.
Understanding The Structure of Private Equity Real Estate Funds
In order to understand how a typical private equity fund structure works, there are at least 10 elements that potential investors should consider.
1. Legal Structure
In a typical fund investment, the legal structure is either Limited Liability Corporation (LLC) or a Limited Partnership (LP). These are companies formed specifically for the creation and administration of a fund. When an individual invests in the fund, they are actually purchasing shares of the company that owns the underlying real estate.
At the end of each year, the fund manager will send a tax document to each individual share owner detailing how much distribution income was earned and how much capital was contributed during the tax year.
There are two groups of partners in a private equity real estate fund.
The first group is known as the General Partner, but may go by several other names like: Sponsor, GP, or Fund Manager. They are the leader of the fund and they have a number of important responsibilities that include: raising investment capital, property identification and due diligence, property management, fund management, and legal and tax compliance. In short, they do all of the hard work of managing investor capital by deploying it into commercial real estate assets and managing the day to day operations of each property.
Investors are known as Limited Partners, “LPs” or just investors. They are individuals who want to earn a return on their capital and choose to do so by investing it in a private equity real estate fund. The LP role is passive, which means that LPs have no say in property management or investment management decisions.
3. Limited Partnership Agreement
Specific roles and responsibilities are outlined in a document known as the Limited Partnership Agreement. It is absolutely critical that investors read and understand the contents of this document prior to writing an investment check. Among other things, it contains a number of critical pieces of information such as:
- Official business name and purpose
- Roles and responsibilities of the General/Limited Partner(s)
- Voting rights and decision making process
- Ownership shares
- Partner capital contributions
- Process for dissolving the entity once the fund matures
Investors need to be aware of and comfortable with these terms.
Some funds have maturity dates, others don’t. Investors should read the offering documents to determine if the fund has a maturity date and to ensure they are comfortable with it. If it does, the key point is that it is likely to be 5-15 years into the future and, as the fund winds down, it may be forced to sell its holdings regardless of market conditions.
5. Preferred Return
In some real estate funds, investors earn a “preferred” return, which means they get 100% of the cash flow and profits produced until they have achieved a certain return on their investment. Once this is the case, any remaining money is split between the general and limited partners in an equitable manner. The math behind a preferred return can be quite complex, but a simple example can illustrate how it works.
Suppose a fund raises $1MM from limited partners and promises an 8% preferred return. This means that investors get 100% of the income and profits produced by the properties held by the fund until they have earned a 8% return. Once they have, they may split any remaining money 50/50 with the fund manager.
Again, these details are outlined in the offering documents and should be understood thoroughly prior to making an investment.
6. Capital Contributions
In the Capital Contributions section of the Limited Partnership Agreement, the total amount of capital raised is described and the required contributions for each party are described. Even within this section, there are two things that investors should look for.
First, investors should look to see if the fund manager is investing any of their own capital in the deal. It isn’t a requirement that they do so, but it can signal their own belief in the success of the real estate fund and is a positive indication for investors.
Second, investors should look to see what the additional capital requirements are beyond their own initial investment. Often, there will be a provision that allows the fund manager to issue a “capital call” when it is needed, which means that investors have to put in additional money if they want to maintain their percentage of ownership. Often, this can come as a surprise so it is important to identify this requirement up front.
To understand their potential payout, investors should look for three things.
First, they should look at the track record of the fund manager to ensure they have a history of providing consistent payouts to their investors.
Second, they should look to see whether or not they are in line for a preferred return and if so, how much.
Finally, they need to understand the profit split between the general partner and limited partners. It should be such that it rewards the general partner for profitable deployment of funds, but not at the expense of limited partners.
8. Private Equity Real Estate Sponsors
For investors, a strong commercial real estate sponsor can make or break the success of the real estate fund. As such, they should be evaluated based on their experience, track record of profitable returns, risk mitigation strategy, clarity of communication, senior management, and regulatory violations.
Much of this information is publicly available. If it isn’t, investors should feel empowered to ask as many questions as they need to feel comfortable that the fund manager is going to be a valuable partner.
9. Motivations & Promoted Interest
In an ideal structure, the financial interests of both the General Partner and Limited Partner(s) are aligned. This is accomplished through the creation of the return structure. It is unique for every real estate fund, so investors must take the time to understand it.
For example, suppose a fund raises $10MM. Of this total, the General Partner puts in $1MM (10%) of their own money and raises the other $9MM from Limited Partners (90%). This capital is deployed into the properties and Limited Partners receive 100% of the cash flow until they achieve an 8% rate of return. Once this hurdle is met, any remaining money is split so that 70% goes to Limited Partners and 30% goes to the General Partner. This extra 20% for the GP is known as a “promote”, which is short for promoted interest.
The point of this structure is that it incentivizes the General Partner to deliver a return in excess of 8%. If they do, they stand to earn a higher percentage of the profit than they put in and investors are happy because they made a good return on their capital.
Finally, all real estate funds charge fees and the type, amount, and structure can vary. For example, firms may charge annual management fees, asset management fees, disposition fees, or debt placement fees.
Investors should carefully evaluate the fee structure to make sure they understand it and to ensure that it is commensurate with other funds in the industry.
Types of Private Equity Funds
There are hundreds, perhaps thousands, of private equity commercial real estate funds. Although they all pursue their own unique investment strategy, they tend to fall into four general buckets.
1. Core Investments
Real estate funds that concentrate on core investments choose to purchase the newest, cleanest, high occupancy properties with a good location that they can find. This type of portfolio tends to offer lower, but stable returns to investors and have the lowest risk for loss of principal.
Examples of core investment property types include things like Class A multifamily apartment buildings, high-rise office properties in a central business district, or a grocery store anchored retail center with high quality tenants. Core funds tend to be a good fit for older investors who prefer preservation of capital over growth.
2. Core-Plus Investments
Core-plus investments incorporate slightly more risk into the investment, but also offer the chance for a slightly higher return. Core-plus properties tend to be slightly older, may need a little bit of work, or are located in secondary markets. For example, a Class B investment opportunity could be an industrial center that needs a bit of work with an out of the way location.
Core-plus investments tend to be a good fr for investors with a slightly higher risk tolerance and those with the ability to keep investments for longer holding periods.
3. Value-Add Investments
A value-add strategy involves properties that may have a good location, but are slightly run down due to wear and tear or mismanagement. Investors with the requisite expertise can purchase these properties for a good price and then execute a turnaround plan to bring them back to market standards. For example, value-add projects could be as simple as a fresh coat of paint and updated landscaping. Or, the renovations can be far more extensive with new building facades or extensive interior renovations.
4. Opportunistic Investments
At the other end of the risk spectrum is an opportunistic strategy. This fund strategy allocates capital to high risk/high return properties or projects. In many cases, these could be existing buildings that require a completed overhaul or ground up real estate development. They are illiquid and could mean that investors have to go years before seeing any return from the property.
Opportunistic investments are the most suitable fit for investors with a high risk tolerance, long time horizon, and have a strong desire to see their capital grow through increased property valuations.
Summary of Private Equity Real Estate Fund Structures
- For individual investors, there are two ways to make a capital commitment to the commercial real estate asset class, through an individual deal or an investment fund.
- An investment fund raises money for the general purpose of investing in commercial real estate and deploys the capital into deals that the fund manager believes will be profitable.
- Investors who prefer the fund structure should evaluate the opportunity based on a number of elements including: Term, Preferred Return, liquidity, capital contributions, carried interest, and sponsor experience.
- In addition, investors should review the investment strategy to ensure it is suitable for their own preferences.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.